What do the ghosts of past market crises tell us about the risk in the current market
05/24/2011 8:30 am EST
Every time oil tumbles or silver plunges I can feel the icy fingers of 2008 creep down my spine and I can hear fear in my email. Should I sell my shares of Freeport McMoRan Copper & Gold (FCX)? I was asked more than once when silver was on its way from $49 to $35? Understandable question. In 2008 shares of the copper and gold miner fell from $57.73 on June 4 to $12.18 on November 26, 2008. Who wants to go through that again?
When Renren (RENN), the Chinese Facebook, goes public at 75 times revenue or when the IPO of LinkedIn (LNKD) soars to more than $120 a share from its $45 offering price before closing at $94 on its first day of trading, it brings back memories of the dot.com bubble that saw Yahoo! (YHOO) rocket 154% on its first day of trading. The dot.com bubble turned into the tech bubble and both eventually burst wiping out not only newcomers like WorldCom but also old established names such as Lucent Technologies and Nortel.
When Greece totters on the edge of default with yields on its 10-year bonds breaking 17%, it revives fears of the mortgage-backed asset collapse that took down Bear Stearns and Lehman Brothers—and almost claimed Citigroup (C) and American International Group (AIG) and the world financial system too.
This remembrance of bears past is a good thing. Fear is as essential to financial markets as hope. Without the latter nobody would buy anything and without the former everybody would buy everything.
But investors are supposed to move from blind panic to rational fear as a crisis moves further and further back into the rear view mirror. (Although it’s always wise to remember “Objects in mirror are closer than they appear.”) We’re supposed to have learned something from a crisis that will make it less likely to repeat in the future, but we’re not supposed to jump at every noise or lock ourselves in a panic room whenever a car alarm goes off.
So what have we learned and what do those lessons tell us about the current likelihood of a crisis turning into a market-shaking bear? (The kind of crisis I’m writing about here is quantitatively and qualitatively different from the kind of ordinary volatility or the 10% correction that investors go through regularly—and that emerging markets officially entered on May 23.)
What we’ve learned (I think) #1: Extreme over-valuation precedes a crisis—you might say it’s a prerequisite.
Caveat to Lesson #1: Extreme valuations are sometimes hard to recognize. The over-valuations of the dot.com bubble were clear to all—even if all thought they could make money as the extreme got more extreme. The extreme valuations in the mortgage-backed asset bubble weren’t nearly as clear—you had to challenge the prevailing risk assessments for these AAA-rated assets in order to see how badly prices were inflated.
Where we are now on the scale of Lesson #1: It depends on what market you’re looking at. If you’re worried about a conventional bubble, I’d say the danger is relatively low.
In emerging markets, for example, their relatively low price to earnings ratios—the trailing 12-month PE for the iShares Brazil Index (EWZ) was just 11 as of April 30, well-below the 15.6 trailing 12-month PE ratio for the Standard & Poor’s 500 stock index--argues that they aren’t going to be the locus of the next blow up. If you’re worried about a bubble in the U.S. domestic stock sectors that have done the best in 2010 and 2011, industrials and materials, their relatively modest relative PE ratios should help reduce your fears. The S&P materials sector trades at a below index PE ratio of 15.3 and the industrial sector is at just 17.2. I say “just” because, first, sectors such as telecom (at 18.9) and consumer discretionary (at 17.5) show higher trailing price-to-earnings ratios and, second, because the PE ratio for the materials sector is down 13.5% the end of 2009 and for the industrial sector it’s up just 0.04%.
Worries about dangers in the Eurozone seem more real. Greece is on the road to default—unless the other countries of the European Union decide to throw more money at the problem. It’s hard for me to see how Portugal avoids going the same route eventually. And if default is the end of the road for these countries, then their bonds, even at the recent yield of 17% for Greek 10-year bonds, are overvalued. (Especially since many banks in Europe haven’t yet marked all their holdings of these bonds to market prices.) And, of course, right now Europe’s financial leaders are hoping that they can hold the line without seeing Spain fall into crisis. I think it’s likely that Spain will skirt the crisis, but if I can certainly understand the depth of the worry. If Spain falls into crisis, then all current mechanisms for dealing with the crisis will turn out to be inadequate.
And, then, as my caveat above says, there are those instances of over-valuation that are hard to recognize in the same way that over-valuation in the mortgage-backed asset market was tough to see. For example, U.S. Treasuries would seem to be over-valued given the long-term problems in the U.S. budget and with the dollar. But are they really? The world currently is willing to pay up for the liquidity and security of this market. As long as that lasts, you can make a case that Treasury values are high but not completely out of line.
China’s property market has all the ear-marks of a bubble and some Chinese stocks are priced in bubble land, but is China as a whole over- valued by enough to constitute a bubble? Certainly bad loans at Chinese banks and massive off-balance sheet debt in the financial sector are legitimate worries but given the Chinese government’s track record of successfully burying bad debt in the past (after the Asian currency crisis of 1997, for example), how much bad debt would be enough to rattle the entire economy?
What we’ve learned (I think) #2: Any bear market or financial crisis needs a trigger of the kind I’ve just run through. But for a correction or even a market plunge to turn into a crisis like the Great Recession set off by the collapse of the market-backed securities market, you need a mechanism for leveraging the damage. The 508-point crash of October 19, 1987 didn’t turn into anything like the Great Recession or even the lingering post-dot.com bear. Why not? A lack of negative leverage to magnify those horrific stock market losses.
In the dot.com/technology bubble, the leverage mechanism was the relationship between share prices and revenue. Shares prices had climbed to bubble levels propelled by investor enthusiasm built at least in part on over-optimistic (and in some cases downright fraudulent) revenue forecasts constructed on vendor financing. (Amazing wasn’t it that when companies were willing to finance customer purchases, customers were more willing to buy.) When stock prices started to fall, companies became less willing to take on debt to buy (or to finance purchases) and Wall Street analysts started to take a harder look at those revenue forecasts. That led to revenue and revenue forecast cuts, that led to more share price declines, that led to more revenue and revenue forecast cuts.
What turned a real estate bubble in the United States, Ireland, the United Kingdom and Spain into a global financial crisis was the leverage in the mortgage-backed asset market. Yes, the inflated price of homes and the mortgage industry’s willingness to lend to anybody with a pulse were necessary prerequisites for the crisis, but without the bundling of those mortgages into securities that were then rated AAA and sold to everybody from banks to insurance companies to pension funds the mortgage crisis would have been limited to institutions invested in individual bubble real estate markets. Add in more leverage in the form of derivatives that let financial institutions think they had laid off risk—and could therefore take on more risk—to counterparties that didn’t in some cases have the resources to absorb that risk and you had a way to turn a local real estate market failure into a global crisis.
I got my call on the mortgage crisis terribly wrong because I didn’t appreciate the power of the mechanisms that the financial industry had created in the mortgage-backed asset and derivative markets to leverage a real estate bubble. And it’s the memory of how wrong I was and why that constitutes my biggest worry about the next crisis. I don’t see a mechanism that would leverage any of the triggers that I’ve mentioned above into a global crisis—but that doesn’t mean they don’t exist.
Where we are now on the scale of Lesson #2:
I think I understand the leverage in the euro crisis and therefore how far it could spread. Even if Spain descends into crisis, I think the damage would be limited to specific European banks with big holdings of sovereign debt from crisis countries. I think it would be a challenge for the European Central Bank, the International Monetary Fund, and the national governments of the European Union to support or wind down these banks, but the problem, I think, is limited to specific banks in Europe rather than endangering the financial system of the world as a whole. (Why so many “I think”s in this paragraph? Because I’m pretty sure that no one understands if or how the credit default swap market could leverage this crisis. Derivatives remain shockingly opaque even after the mortgage-backed asset disaster.
I can see a mechanism for turning a Chinese bad debt crisis into a global economic slowdown but I don’t see the leverage that would turn that slowdown into a global crisis. If China’s economy slowed as the country dealt with a flood of bad debt, that would slow growth in commodity-producing countries such as Australian and Brazil, and in economies that export finished goods to China such as Germany. But these countries are in much better shape to absorb such a decline in growth than the export economies of Asia were in 1997 and it’s hard to see Brazil or Germany or Australia needing an rescue led by the Federal Reserve and the International Monetary Fund as Thailand and Indonesia did in that earlier crisis.
I can’t see a mechanism for turning a crisis in the U.S. Treasury market into another global financial crisis—but that doesn’t mean there isn’t one. The global crisis that started with mortgages reminds me that the financial markets are connected by newly invented financial derivatives and by interlocking risk-management strategies in ways that can produce unanticipated effects. I don’t see a way that a drop in Treasury prices of the sort that Pimco’s Bill Gross anticipates would result in the drying up of short-term credit across the globe or a collapse in the balance sheets of the world’s banks. But the mortgage-backed asset crisis tells me that just because I can’t see it doesn’t mean it doesn’t exist.
Which, leads me to What we’ve learned (I think) #3: The next crisis won’t be a replay of either of the last two, just as the mortgage-backed asset crisis wasn’t as replay of the dot.com/technolog bubble.
I don’t mean to either scare you by running through the possibilities or to make you start singing “Don’t worry, be happy” either. Turtles that can’t stick their legs and head out of their shell never make it to the next pond—but neither do they get eaten by coyotes.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/